The G-7 Weighs in on SIFI Designations

The Treasury and Federal Reserve, afraid of congressional opposition, sought G-7 support for accelerated SIFI designations of capital markets firms.

Early in June, in the midst of serious discussions about the global economy, Ukraine, climate change, and dealing with an expansionist Russia, G-7 leaders took time out to express concern about a matter well beneath their usual remit — that progress has been too slow in setting up a framework for regulating the financial firms they call “shadow banks.”

In their communique from Brussels, the leaders of the world’s most important countries promised that “2014 will be the year in which we focus on … relevant shadow banking activities with clear deadlines and actions to progress rapidly towards strengthened and comprehensive oversight and regulation appropriate to the systemic risks posed.”

Statements like this from the august G-7 are not easy to get, so the fact that the leaders spoke on shadow banks at all reflects a sense of urgency in the bureaucracies that run both the Financial Stability Board (FSB), an international organization of central bankers and bank regulators, and the Financial Stability Oversight Council (FSOC), a U.S. agency set up by the Dodd-Frank Act and composed of the heads of all the U.S. financial regulators. The Treasury and the Federal Reserve are important members of both organizations. It is likely that they needed a G-7 endorsement for an expedited effort this year to gain regulatory control of the capital markets players they define as shadow banks.

If capital markets firms are designated as SIFIs and subjected to bank-like regulation by the Federal Reserve, the consequences for the U.S. economy would be dire.

In 2009, in the wake of the financial crisis, the FSB was deputized by the G-20 to bring reform to the international financial system. Since then, the group has used this mandate to promote the extension of bank-like regulation and supervision to nonbank financial institutions in member countries. Its method has been to label large financial firms as “systemically important financial institutions,” or SIFIs, if their failure — in the FSB’s view — will endanger the stability of the international financial system. The FSB has no enforcement power, but leaves it to the home countries of these firms to subject them to special regulation and supervision.

In the United States, the FSB’s directions would be carried out by the FSOC. Up to now, the FSOC has followed the lead of the FSB. For example, in July 2013, the FSB designated nine insurers — including three U.S. insurers, AIG, Prudential Financial, and MetLife — as global SIFIs; shortly thereafter, the FSOC designated AIG and Prudential as SIFIs, and it is investigating MetLife for this purpose. Under Dodd-Frank, when a firm is designated as a SIFI it is turned over to the Fed for bank-like supervision and more stringent regulatory controls.

In September 2013, the FSB turned its attention to “shadow banks,” announcing that it is “reviewing how to extend the SIFI Framework to global systemically important nonbank noninsurance financial institutions.” This category of firms, said the FSB, “includes securities broker dealers, finance companies, asset managers and investment funds, including hedge funds.” Given the size of the U.S. capital markets, all of these firms are likely to be U.S. financial institutions.

Pursuing this idea, in January 2014 the FSB stated that asset managers with more than $100 billion under management — again, all U.S. firms — should be considered for SIFI designation; the FSOC then dutifully followed suit, commissioning an initially secret study from a Treasury agency (later, embarrassingly, posted on the Securities and Exchange Commission’s website) that explained how asset managers could create systemic risks.

It seems likely that the Treasury and the Fed are reacting to the fact that the U.S. Congress has now awakened to the significance of what the FSOC is doing.

If capital markets firms such as broker dealers, investment funds, and hedge funds, among others, are designated as SIFIs and subjected to bank-like regulation by the Fed, the consequences for the U.S. economy would be dire. The dynamism of U.S. business follows from the fact that it is financed largely by the capital markets and not by banks. Since the mid-1980s, the capital markets have outcompeted the banks as corporate financing sources and the gap has been growing ever larger. Putting the Fed in charge of regulating the major capital markets players would reduce their risk-taking and innovativeness, and designating them as SIFIs would in effect be declaring that they are too big to fail, undermining competition in every market where a SIFI operates.

The interesting question is why the FSB and the G-7 thought it necessary at this point to set a 2014 deadline for implementing the FSB’s “SIFI Framework” for shadow banks. The FSB, like the FSOC, is not a transparent organization; what both groups do, and why they do it, is almost entirely opaque to outsiders.

However, it seems likely that the Treasury and the Fed are reacting to the fact that the U.S. Congress has now awakened to the significance of what the FSOC is doing. Growing opposition in Congress could mean that further SIFI designations will be seen as defying strong congressional opposition, a dangerous approach for government agencies when many observers are predicting that the Republicans will take control of the Senate in 2015. The Treasury and the Fed’s plan may be to get initial designations done before Congress is fully engaged and the Senate is in Republican hands.

But Congress is now increasingly engaged. In January, for example, a bipartisan group of senators wrote to Treasury Secretary Jack Lew protesting the poor quality of the Treasury study and arguing that FSOC should not designate any asset managers until the Fed explains how they will be regulated. In April, 41 House Democrats and Republicans signed a letter to Secretary Lew cautioning the FSOC against designating asset managers as SIFIs.

In May, chairman Jeb Hensarling and all subcommittee chairs of the House Financial Services Committee sent a letter to Secretary Lew and others seeking information and documents on communications with the FSB, and, at a hearing in the House Financial Services Committee, chairman Hensarling called on the FSOC to “cease and desist” on further designations until Congress has had an opportunity to consider the consequences for the economy. A bill has now been introduced in the committee that would impose a six-month moratorium on further designations.

Whether these warning shots will be enough to slow down the FSOC’s designation process remains to be seen, but the auguries are not good. Despite the Senate and House letters, the FSOC let it be known in late April that it is focusing on Fidelity Investments and BlackRock, Inc., both large asset managers, for possible designation as SIFIs. All indications are that the Treasury and Fed have accelerated the pace of designations so that they can create a fait accompli before the 2014 elections. The FSOC clearly has authority under the Dodd-Frank Act to designate any financial firm as a SIFI; the G-7’s statement shows that the Treasury and the Fed thought it necessary to get political support at the highest level for making initial designations of capital markets firms in 2014. In this high stakes political contest, if the financial industry wants to slow or stop the designation process, its only recourse is to get key members of Congress to take its side.